March 23, 2017

FROM THE UNIFORM LAW COMMISSION: In the World of Alternative Entities What Does “Good Faith” Mean?

Daniel S. Kleinberger

With this issue, in cooperation with the Uniform Law Commission, we initiate a column on the law of incorporated entities, principally, limited liability companies The column will appear every other month and discuss issues as they develop around the country.

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Over the past several decades, “good faith” has become increasingly important in the law of business organizations. The phrase appears five times in the newest version of the Uniform Limited Liability Company Act (ULLCA (2013)), more than 40 times in the official comments, and has similar importance in the newest versions of the uniform general and limited partnership acts. The phrase also has fundamental importance in the Delaware law of “alternative entities” (discussed below) and was central cases clarifying the reach of liability-limiting charter provisions under Delaware corporate law’s famous section 102(b)(7).

One might think, therefore, that “good faith” can be defined easily or, at least, definitively. But the term is polysemous, a chameleon whose meaning changes dramatically depending on the context. Depending on context and on jurisdiction, the term indicates a test that is either entirely subjective or has both subjective and objective aspects. In one context, the objective standard is a very lax duty of care reclassified as part of the duly of loyalty. In another context, the word “objective” has a meaning radically different from the “reasonableness” concept typically associated with an “objective” test.

This column concerns the law of limited liability companies and partnerships, where the most important context for “good faith” is the implied contractual obligation (or covenant) of good faith and fair dealing. The obligation, which is not a fiduciary duty, originated in the common law of contracts but in recent has years developed its own, special character as applied to operating and partnership agreements.

The goal of this column is to explain how LLC and partnership law understand and apply the implied contractual covenant. We start where the obligation originated, consider briefly the codification provided in the Uniform Commercial Code (UCC), and then address the special character reflected in Delaware law and the newest versions of the uniform LLC and partnership acts.

Under the common law of contracts, the obligation of “good faith and fair dealing” is an implied and inescapable term of every agreement. Per the Restatement (Second) of Contracts, § 201, “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” The official comments suggest that a complete definition is impossible—the duty “excludes a variety of types of conduct characterized as involving ‘bad faith’ because they violate community standards of decency, fairness or reasonableness,” but “[a] complete catalogue of types of bad faith is impossible.”

This type of impossibility is a boon to litigators and a bane for transactional lawyers. “Good faith,” as codified by the Uniform Commercial Code (UCC), is little better. Under UCC, § 1-201(20), “‘[g]ood faith’ . . . means honesty in fact and the observance of reasonable commercial standards of fair dealing.” Presumably, the UCC’s concept of usage of trade imparts some content to “reasonable commercial standards of fair dealing.” Nevertheless (and arguably as a result), those standards assess a contract obligor’s conduct from a perspective disconnected from the language of the contract. The results can be startling, as in K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985), which used such standards to hold that: (i) a lender’s exercise of its totally discretionary right to call a demand note was objectively unreasonable; and therefore (ii) the lender was liable for the collapse of the borrower’s business.

As will be seen, the uniform acts and Delaware law are more friendly to transactional lawyers (and their clients), although both the ULC and Delaware case law have flirted at least briefly with an objective standard divorced from the words of the parties’ agreement. For example, in Policemen’s Annuity & Benefit Fund of Chicago v. DV Realty Advisors LLC, No. CIV.A. 7204-VCN, 2012 WL 3548206 (Del. Ch. Aug. 16, 2012), the Delaware Court of Chancery considered the implied covenant in the context of a limited partnership agreement which required the limited partners to act “in good faith” if they chose to remove the general partner but did not define good faith. The court decided to “presume that the parties intended to adopt Delaware’s common law definition of good faith as applied to contracts” and then resolved the matter in light of the UCC definition of the implied convent—including that definition’s objective aspect.

On appeal, DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101(Del. 2013), the Delaware Supreme Court affirmed the judgment but flatly ended the flirtation: “This Court has never held that the UCC definition of good faith applies to limited partnership agreements.”

Recent Delaware decisions have moved toward greater precision, mooring both “good faith” and “fair dealing” to the words of the parties’ contract. The pivotal case is Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418-19 (Del. 2013) in which the Delaware Supreme Court stated:

“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care . . . It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties’ agreement and its purpose. Likewise, “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose, and terms of the parties’ contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.

Gerber further explained that, because the actual words of the agreement control the application of the implied covenant:

An implied covenant claim . . . looks to the past. It is not a free-floating duty unattached to the underlying legal documents. It does not ask what duty the law should impose on the parties given their relationship at the time of the wrong, but rather what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.

(Emphasis added.)

At one time, the Uniform Law Commission (ULC) appeared to do more than merely flirt with the vagueness of the common law/UCC approach. In RUPA Section 404(d), a uniform act codified the implied covenant of good faith and fair dealing for the first time. Comment 4 to that section stated:

The meaning of “good faith and fair dealing” is not firmly fixed under present law. “Good faith” clearly suggests a subjective element, while “fair dealing” implies an objective component. It was decided to leave the terms undefined in the Act and allow the courts to develop their meaning based on the experience of real cases.

Having courts “develop” meaning as they go hardly makes for the rule stability that transactional lawyers seek. In 2001, the ULC adopted a new uniform limited partnership act with the same codifying language, ULPA (2001), § 305(b), but the official comment to the provision took a decidedly different approach:

The obligation of good faith and fair dealing is not a fiduciary duty, does not command altruism or self-abnegation, and does not prevent a partner from acting in the partner’s own self-interest. Courts should not use the obligation to change ex post facto the parties’ or this Act’s allocation of risk and power. To the contrary, in light of the nature of a limited partnership, the obligation should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made.

About a decade later, the ULC began a project to harmonize both the language and commentary of uniform unincorporated business entity acts. The uniform general partnership, limited partnership, and limited liability company acts each codify the implied covenant, and the harmonization project changed both the statutory language and the official commentary. All three acts now expressly characterize the implied covenant as “contractual.” And, in their respective official comments, all three acts interweave the 2001 “non-abnegation” language with quotations from the Delaware cases quoted above.

Thus, under both Delaware law and the uniform acts, the implied obligation of good faith and fair dealing is a cautious enterprise, intended only to preserve the fruits of the bargain—as evidenced by the words of the contract—from one party’s lack of prescience and the other party’s desire to exploit that lack. As Vice Chancellor Laster explained in Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005 (Del. Ch. June 20, 2014)

No contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency. Even the most skilled and sophisticated parties will necessarily fail to address a future state of the world . . . because contracting is costly and human knowledge imperfect. . . .

Thus, properly understood and delimited, implied covenant analysis resembles the rule for determining whether a party’s contractual duties are discharged by supervening impracticably. As explained in Restatement (Second) of Contracts § 261, cmt. b (1981): “In order for a supervening event to discharge a duty . . ., the non-occurrence of that event must have been a ‘basic assumption’ on which both parties made the contract.” As for the implied contractual covenant, again in the words of Vice Chancellor Laster in the El Paso case, “parties occasionally have understandings or expectations that were so fundamental that they did not need to negotiate about those expectations.”

Or put another way: both doctrines identify situations or claims that—if contemplated at the time of contracting—would have been deal breakers.

In the next column—“Delineating the Implied Covenant and Providing for ‘Good Faith’”—can an operating or partnership agreement shape the implied covenant, even to the extent of creating safe-harbors? What should never be done when making “good faith” an express requirement?

Daniel S. Kleinberger

A graduate of Harvard University (A.B. 1972, summa cum laude) and Yale Law School (J.D. 1979), Daniel S. Kleinberger is Emeritus Professor of Law at Mitchell Hamline School of Law in Saint Paul, MN, where he taught business law for 28 years. Since 1997, Professor Kleinberger has served as Reporter or Co-Reporter for five major projects of the Uniform Law Commission. He serves regularly as a testifying and consulting expert, as a member of or counsel to special litigation committees, and as special counsel to determine an individual’ right to advances or indemnification. His scholarly work has been cited by the Third, Seventh, Eighth, Tenth, and Eleventh Circuits of the Federal Courts of Appeal, various federal district courts, the New York Court of Appeals, the Supreme Court of Georgia, the Minnesota Supreme Court, the Supreme Court of South Dakota, the Supreme Court of Tennessee, the California Court of Appeals, the New Mexico Court of Appeals, the federal bankruptcy court, and Delaware Court of Chancery, as well as the Restatement of Agency, and the Restatement of Employment Law.